A risky company issues a one-year corporate bond. The market believes that there is an 8%...

 

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A risky company issues a one-year corporate bond. The market believes that there is an 8% chance that bondholders will receive the entire principal but no interest, and 87% chance that they will be paid in full and a 5% chance that bond holders will receive a recovery amount lower than the principal. What recovery amount does the market expect, given that the bond has a promised yield of 10%, and the risk free rate is 5%. To simplify matters, assume, as we have done in class, risk neutrality. A risky company issues a one-year corporate bond. The market believes that there is an 8% chance that bondholders will receive the entire principal but no interest, and 87% chance that they will be paid in full and a 5% chance that bond holders will receive a recovery amount lower than the principal. What recovery amount does the market expect, given that the bond has a promised yield of 10%, and the risk free rate is 5%. To simplify matters, assume, as we have done in class, risk neutrality.